This is what the economic prophet of doom is saying now

February 25, 2016 | Kim Iskyan

To a lot of investors, bonds are boring and confusing – and, worse, the returns they offer are often low. Stocks are (on the surface) more straightforward, and you can make (and lose) a lot more money with them. And while you can brag about the great stock you just bought, you’ll get laughed out of the room if you start to talk about the great bond you just bought.

But bonds are anything but dull. “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter [that’s like a batting average of 100 runs per inning in cricket]. But now I want to come back as the bond market. You can intimidate everyone,” said James Carville, who was a political strategist for U.S. President Bill Clinton.

Bond markets can also tell the future. The U.S. Treasury bond yield curve (which I’ll explain in a moment) has a stellar record of predicting recessions. And what it’s saying isn’t good, for the U.S. economy – or for the global economy, as the U.S. remains the world’s largest economy, and a big source of demand for all of Asia.

The yield curve shows the difference between long-term (10 years or more) and short-term (usually two years) yields on bonds. The yield is the return investors would earn each year if they buy the bond, and hold it until it matures.

Normally, bonds with a longer time to maturity will have a higher yield than those with a shorter maturity. This is because there is more risk in holding a longer-term bond. Over a 10-year period there is more chance of things changing – like interest rates, how the economy is doing, government policy – than over a 2-year period. So investors are usually paid more to take this extra risk.

When the economy is growing and investors are confident, the yield curve will show a larger spread (that is, difference) between the yields on long-term bonds and short-term bonds. (See the “normal” yield curve below).

The graphs below show the basic shape of a normal and an inverted yield curve. Normally, the shorter the maturity of the bond, the lower the yield.

When the yield curve “inverts”, it means that the yield on long-term bonds is less than the yield for short-term bonds. In other words, investors see more risk in short-term bonds than in long-term bonds. This might not sound logical.

But there’s a good reason for this. If investors are worried the economy is headed for a recession, they will look for ways to keep their money safe. If they think stock prices will fall, and that interest rates will fall, they will put their money in long-term government bonds to ride out the storm.

As more and more investors do this, the price of longer maturity bonds goes up. When bond prices go up, yields go down.

At the same time, at that point in the cycle, investors will avoid short-term bonds, because these might mature when interest rates are still low – which isn’t a good time to reinvest money. So, demand for short-term bonds falls, and those yields go up as a result.

With long-term yields falling and short-term rates rising, it doesn’t take long for the yield curve to invert. In the U.S. bond market this has historically meant a U.S. recession is coming. The U.S. Treasury yield curve has been flat or “inverted” ahead of every single U.S. economic downturn since 1976. It’s only been wrong once in history, in 1966.

This is shown in the graph below. When the spread between U.S. 10-year Treasury bonds and U.S. 2-year Treasury bonds falls below zero, a recession follows, as shown by the shaded areas. The arrow shows where the spread is now.

The last time the U.S. yield curve inverted was in August 2006. It accurately predicted the recession that officially began in December 2007, but really took hold in 2008. Before that it predicted the 2001 recession by inverting in April 2000.

So what is it saying now?

Since its 2015 highs, the spread has been shrinking, meaning the curve has been getting flatter, but not inverting. Long-term rates are still higher than short-term rates, by a bit less than one percentage point.

But, there are a few important points to remember. One is that short-term interest rates, which closely follow central bank interest rate decisions, are close to zero in many markets around the world. They have never been this low for this long. Some people think that if short-term rates were in a normal range, the yield curve would have already inverted.

And the huge amount of central bank support (through quantitative easing and other measures) in recent years might have distorted the way bonds work.

Second, even though long-term rates are still higher than short-term rates, long-term rates have also never been this low. This shows that many investors still feel safer holding long-term bonds than almost anything else. They continue to buy them even though the current yield on a 10-year U.S. Treasury bond is just 1.72 percent.

Recently the spread between U.S. 10-year bonds (long-term) and 2-year bonds (short-term) fell below 100 basis points, or 1 percent, for the first time in eight years. The last time the yield spread was this narrow was during the height of the 2008 global financial crisis.

The yield curve has not inverted, and it may never invert as long as short-term rates hover around zero percent. But if investors are buying a lot of longer term treasuries and yields are getting closer and closer to extremely low short-term bond yields, it’s not a good sign.

And in other markets, the yield curve doesn’t always invert before a recession. Japan has had four official recessions since 1995, and its yield curve has not inverted once during that time. And what has the Bank of Japan kept short-term interest rates at over this same period? Almost zero percent.

Similarly, the German yield curve flattened but didn’t invert before it had a brief, shallow recession in 2012-2013. During that time, short-term interest rates across Europe, as set by the European Central Bank, were below 1 percent, and falling.

So, with questions about the global economy on everybody’s mind, keep an eye on the U.S. yield curve. If it continues to narrow, or somehow inverts, and it lives up to its reputation as the best predictor of tough economic times, a recession could follow. That would be bad for economies – and markets – throughout Asia.

About Kim Iskyan

Kim Iskyan has nearly 25 years of experience as a stock analyst, hedge fund manager, political risk consultant, and financial commentator in more than half a dozen emerging and frontier markets.

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